Jamie Dimon is Barking Up the Wrong Tree

My colleague David Reilly has written an interesting Heard column drawing attention to recent comments by JP Morgan boss Jamie Dimon in which he complains that European banks are gaming the Basel 2 capital rules to boost their reported capital ratios.

He questioned differences in models other banks use to calculate risk-weighted assets that help determine Tier 1 ratios. A comparison of J.P. Morgan’s risk-weighted assets to peers suggests their approach “can’t be accurate,” Mr. Dimon said at his bank’s investor-day conference last month. “I mean, obviously, someone’s using far more aggressive models.” Although Mr. Dimon didn’t single out particular institutions, it appears he was pointing a finger at Europe.

Risk weightings of assets measure the threat of loss posed by different holdings. So, a government bond will receive a lower risk weighting than a “junk” bond. A lower risk weighting for a bank’s total assets may allow it to hold less capital. That can help boost returns and profit.

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Determining risk weightings relies on complex calculations and judgments. In the U.S., banks calculate them based on an older, restrictive version of international capital standards. European banks use an updated version allowing wider discretion through management’s use of internally devised risk models.

The result: Major European banks’ risk-weighted assets at the end of the third quarter were about 27% of total assets; at U.S. banks, they were 54%, according to a December report by Goldman Sachs. Some of this may be due to differences in holdings, such as big European banks holding far fewer mortgages. But the difference still is striking, especially given similarities in investment-banking operations.

This is an important issue that we’ve discussed before here and here. I’ve heard the same complaint from some European banks who claim that since rivals report lower RWAs as a proportion of total assets, they must be using less conservative models to calculate risk weights.

The snag is that it’s impossible to prove. I’ve pored over bank Pillar 2 filings, talked to chief financial officers, regulators, bankers and analysts and I’ve not been able to turn up any conclusive evidence that European bank are under-reporting their RWAs for any given class of exposure. The wide headline variation between European banks reflects different balance sheet composition: mortgages currently carry a far higher risk weighting than trading book exposures so traditional lending banks such as Santander and Lloyds Banking Group tend to have far higher RWAs as a proportion of total assets than those such as Deutsche Bank, Barclays, Credit Suisse and UBS with large investment banking operations. Without far more information than is publicly available, it is hard to know whether smaller asset class-level discrepancies reflect easier assumptions or different underlying risks.

That does not mean that there isn’t widespread abuse of internal models. The wide discretion allowed to individual banks and regulators under Basel 2 and 3 is a clear problem, as some of the top policymakers in Europe have privately acknowledged to me. While the Basel Committee has devoted huge effort to every aspect of the bank capital ratio calculation, new rules to ensure greater consistency of models represents unfinished business: by exposing bank capital ratios to this kind of damaging speculation, the Basel rules are contributing to the current loss of confidence.

For European banks, the answer is not to junk internal models and return to standard risk weightings which make no allowances for risks but to take steps to improve confidence in the quality and consistency of internal models across banks and countries. The Basel Committe has proposed asking national regulators to review model portfolios to highlight differences in approach. Another solution would be to introduce peer review among regulators. If the European Banking Authority really wanted to enhance the credibility of its stress tests, this would be one way to do so. After all, presumably not even Mr. Dimon believes that all 27 European national banking regulators have been colluding to rig internal models to gain a collective advantage over the U.S. banks.

Still, even if the Basel Committee could find ways to enhance confidence in internal models, that still wouldn’t address Mr. Dimon’s gripe that European banks have a competitive advantage in the capital rules since the U.S. has still not adopted Basel 2 and is still using the old, original Basel standard models. The U.S. failure to adopt Basel 2 pre-crisis was a significant factor in the build-up to the crisis as it created the conditions for substantial regulatory arbitrage. In theory, this competitive disadvantage should disappear when the U.S. adopts Basel 3, assuming it ever does, since U.S. banks will then be free to use their own models, although the Dodd-Frank Act may place extra burdens on them.

If Mr. Dimon is genuinely worried the rules are rigged against JP Morgan, he should demand that U.S. policymakers level the playing field. Lashing out at European banks without credible evidence just makes JP Morgan look weak.

Comments (5 of 12)

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Risk at all financial levels gets accelerated in a zero interest rate environment. The price of money in the US conditions the actions of Dimon, Europe and me. Zero interest policy makes it hard for any investor to make a living and Dimon/JPM is no exception,